Asset Allocation Committee Outlook
—Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class
The first quarter of 2021 brought what we expected: a new U.S. administration and a new fiscal stimulus; the beginnings of the global vaccination program that should ultimately consolidate the re-opening of our economies; improving economic data worldwide; outperformance from commodities and from small-cap, value and cyclical stocks, with occasional volatility concentrated in large-cap growth; and a sell-off, albeit stronger than we anticipated, in Treasuries. As it looks to the next six to 12 months, the Asset Allocation Committee (“the AAC” or “the Committee”) faces two questions. Do we think the economy will overheat, pushing bond yields to levels that unsettle equity markets or even force central banks to stifle the recovery? And have markets moved enough to justify some rebalancing of last quarter’s views? Our answers are “no” and “yes,” respectively, but we maintain a hawkish eye on the economic data—and particularly the inflation thermometer.
In our last Asset Allocation Committee Outlook, our main concern was the high levels of optimistic consensus. We followed the consensus with our positive views on commodities, small caps, value and cyclical stocks, and with our concerns over the vulnerability of core government bonds. We expressed those views moderately, however, as we thought there was still enough uncertainty and potential volatility to offer “more opportunities to lean into the recovery as it develops.”
We got the outperformance from “recovery assets” and the sell-off in Treasuries that we expected. We also got the volatility—equity markets stumbled at the end of January and again at the end of February. Where we were surprised, it was by the speed and extent of the rise in Treasury yields and the relative shallowness of the equity market dips.
This is an important dynamic, as it tells us a lot about the forces behind the AAC’s first big question: How likely is it that Treasury yields could run out of control?
Since closing at 52 basis points on August 4 last year, the U.S. 10-year Treasury yield has risen rapidly to its recent high above 1.75%. More than half of this move has come in the past three months. While that has knocked several percentage points from the value of many fixed income portfolios, and reintroduced some volatility into equity markets, particularly among longer-duration large-cap growth stocks, it has not stopped the S&P 500 Index from reaching record highs.
Rising interest rates can have a negative effect on the valuations of risky assets, but that is not always the case because the main cause of higher rates is not always the same. Long-term rates are chiefly determined by expectations for economic growth, expectations for inflation and the level of uncertainty about the future path of short-term rates. History suggests that risk assets tend to fare poorly when yields rise as part of the tightening of financial conditions associated with new uncertainty about monetary policy, as they did during the “Taper Tantrum of 2013.” When they rise because of stronger growth and closing output gaps, however, as they did during the winter of 2001, the summer of 2003, the spring of 2011 and the winter of 2010 – 11, risky assets have tended to perform well or at least maintain their levels.
For the next two or three years, we anticipate above-trend economic growth, supported by fiscal stimulus, high household savings, robust corporate balance sheets and the changed consumption patterns associated with a likely continuation of “hybrid” on-site and remote working. The Federal Reserve recently revised its 2021 U.S. growth forecast up to 6.5%, in line with the OECD’s new projection, following confirmation of the Biden administration’s new fiscal stimulus. At the same time, overall financial conditions are likely to remain exceptionally easy. Even Treasury yields at today’s higher levels remain low by historical standards, while equity markets are buoyant and credit spreads are tight.
With growth rates high, financial conditions accommodative and output gaps closing, we anticipate higher inflation over the next few years—in line with the 2.0 – 2.5% levels seen in some years following the financial crisis.
The Federal Reserve reasserted at its March policy meeting a commitment to targeting long-run average inflation of 2% rather than a current rate of 2%, and a determination to respond to actual economic data rather than forecasts—including forecasts implied in financial markets. Taken together, this gives us a “reactive” central bank as opposed to the old, “pre-emptive” model. Before it tightens policy, it appears that the Fed will need to see very strong evidence that inflation is problematically high, in the 3 – 4% range, and structural rather than temporary.
So far, the Treasury market has not priced for this kind of outcome. Some of the more volatile, short-term market-derived inflation expectations have risen above 2.5%. For comparison, however, the five-year breakeven inflation rate starting in five years’ time, which is the Federal Reserve’s favored indication of the market’s long-run average inflation expectations, is still only just above 2%.
In addition, the uniqueness of the current environment is likely to give the Fed exceptional latitude to stay on the sidelines. We believe the low base set last year makes it much easier to dismiss high inflation this year as a statistical aberration. A dearth of spending on services in 2020 is likely to be contrasted with a splurge of pent-up consumption in the summer of 2021. A spree on durable household goods and computer equipment in 2020 is likely to be contrasted with indulgence on holidays and nights out in 2021. Most banks and many corporations and consumers are coming out of recession with unusually robust balance sheets. When the economic data is so abnormal, not acting upon it is easily presented as prudent.
Putting all of this together, there is consensus on the Committee on three important points.
The first is that the sell-off in nominal Treasuries may have happened faster than is warranted by current conditions; we anticipate more two-way trading and less momentum in Treasuries from now on. In particular, we believe a U.S. 10-year yield in the current range is high enough to attract euro- and yen-based investors, which is likely to be a significant headwind to much higher rates.
The second is that, even if the U.S. 10-year yield were to push to 2% or higher, that alone would be insufficient to elicit more hawkish rhetoric from the Fed; by contrast with the 2013 “Taper Tantrum,” we think 2021 will be remembered for its “Taperless Tantrum.”
And the third point of consensus is that the Fed is likely correct to forecast a spike in inflation this year followed by a return to 2.0 – 2.5% thereafter.
Consensus does not mean unanimity, and every Committee member emphasizes the importance of a close watch over the economic data. Over the coming months, some of that data could hit levels unseen for 40 or 50 years, unsettling markets. On the whole, however, those three assumptions underpin this quarter’s decisions on our asset allocation views.
These assumptions support a continuation of our pro-risk and pro-cyclical stance. The improving growth outlook is feeding into earnings forecasts: for the S&P 500, the analysts’ consensus is now for $200 per share this year, up more than 40% on 2020’s results. Were the 10-year U.S. Treasury yield to top out below 2.25%—a level we faced in early summer 2019, when the U.S. was growing at 2.2% rather than 6.5%—the effect on valuation multiples would be highly unlikely to wipe out the big boost to earnings.
As such, we maintain overweight views on equities and credit over core government bonds; U.S. small caps over large caps; non-U.S. over U.S. equities; and commodities and private markets over hedged strategies. The Committee continues to favor cyclical over defensive sectors and value over growth stocks.
That said, markets have moved decisively, consistent with these views over the past two quarters. As well as the jump in Treasury yields, 12-month trailing performance data in general is beginning to show remarkably big numbers. As of March 31, 2021, The Russell 2000 Index of small caps is up almost 95% over that period, almost 35 percentage points ahead of the Russell 1000 Index. The Russell 1000 Growth Index still leads the Russell 1000 Value Index over 12 months, but the Value Index has already raced ahead by more than 10 percentage points since the start of 2021. The Bloomberg Barclays Global High Yield Index is up almost 25% over 12 months, versus less than 5% from the Global Aggregate Index. The price of copper has doubled.
That brings us to our second question: Have markets moved enough to justify some rebalancing of last quarter’s views?
We have seen enough to change a few of our headline views. The AAC has moved investment grade fixed income up from an underweight to a neutral view: we have upgraded what we regard as oversold Treasuries, and even as spreads have tightened on high grade credit, we recognize new opportunities in some longer-duration bonds as a result of higher yields. The pronounced underweight view on non-U.S. developed market debt has also been eased, given the move in yields.
For the most part, however, our views might infer more subtle changes to asset allocation weights, depending on the balance within individual portfolios. For example, if the outperformance of small caps, value, non-U.S. markets, high yield and commodities has tipped these exposures out of balance, then taking profits on the margin may appear prudent, particularly as long-duration exposures such as nominal government bonds and large-cap growth stocks look less vulnerable to us now than they did before the recent run-up in rates. Overall, however, we are staying the course with our key views from the start of the year.
We also continue to anticipate potentially pronounced periods of volatility, which could be used to lean portfolios further into pro-recovery allocations as the year unfolds. While the Fed’s firm messaging may reduce some uncertainty, economic data surprises could increase it; and the Committee notes a range of other live risks, from a flare-up in relations with China to a taxation sticker shock, an attack on the U.S. Congressional filibuster or a partisan tussle over the third-quarter U.S. debt ceiling.
For now, it appears that the leading concern for investors is the recent momentum behind Treasury yields and what it implies for inflation and the trajectory of central bank policy over the next 12 to 24 months. The temperature is rising, and the summer could bring some very hot data. Like other summer heatwaves, we expect this one to be the topic of a lot of conversation, but cause only temporary discomfort—although we will be keeping a very close eye on the thermometer.
- The Asset Allocation Committee (“AAC” or “the Committee”) upgraded its overall view from underweight to neutral.
- Government bonds appear less risky and subject to more two-way trading after the recent run-up in yields.
- Conservative balance sheet management is positive for investment grade credit, and while spreads are unlikely to tighten much further, higher yields have opened up some new opportunities in longer-duration corporate bonds.
- The Committee upgraded the asset class to underweight from its previous, very underweight view.
- Yield curves remain suppressed and flat and there is scope for interest-rate volatility in the earlier stages of economic recovery: the view remains underweight, but the recent run-up in yields has made these markets less risky than they were at the beginning of the year.
- The Committee maintained its overweight view.
- An environment of low rates and conservative management of corporate balance sheets will be supportive of credit markets in general.
- Our estimate for the default rate over the next 12 months has declined meaningfully since the height of the crisis.
- While not affecting credit spreads, in our view the recent run-up in Treasury yields has created value in higher quality issuers, particularly “fallen angels” that have the potential to become upgraded “rising stars” over the coming 12 – 24 months.
- The Committee maintained its overweight.
- Because emerging markets debt indices are heavily weighted to Latin American countries struggling with coronavirus and recent U.S. dollar strength, the asset class appears to be trading relatively cheaply.
- Economic growth and commodity strength should be supportive of emerging markets fundamentals and ultimately overwhelm the potential headwinds triggered by higher rates or a stronger U.S. dollar, particularly in hard currency bonds.
- With the major exception of the China onshore market, we are more cautious on local currency bonds in light of higher inflation and a shift to tighter monetary policy, as well as rising risk premia in response to several large fiscal stimulus packages.
- The Committee maintained its underweight view on U.S. large caps and its overweight view on U.S. small and mid caps.
- U.S. large caps, particularly the secular growth stocks that led last year’s recovery, have lagged since the start of the year mainly over concerns about their exposure to rising interest rates—although the AAC regards them as less risky after the recent run-up in Treasury yields.
- Large-cap cyclical and value stocks have outperformed, however, and could continue to do so as economies begin to open up fully later in the year.
- The AAC also believes a tilt toward higher quality small caps is justified as economic recovery takes hold.
- The AAC anticipates opportunities to add risk in small caps, value stocks and cyclical stocks during potential periods of volatility as the recovery develops.
- The Committee maintained its overweight view.
- U.S. large caps have led the rapid recovery in financial markets and now appear fully valued, whereas Japanese and European equities remain relatively cheap and are also more highly geared to global trade and the general economic recovery anticipated in 2021.
- On the margins, the AAC favors Japan, where big changes in management attitudes to shareholder value are creating substantial opportunity, over Europe, where countries are struggling with a new wave of coronavirus infections and a difficult vaccine rollout.
- The Committee maintained its overweight view.
- Emerging markets are highly geared to global trade and the general economic recovery anticipated in 2021.
- China and Asia more broadly stand out as sources of high-quality exposure to global economic recovery.
- Emerging markets equities could benefit from U.S. dollar weakness, which we anticipate on a 12- to 18-month view, although caution on this continues to be warranted in the immediate term.
- The AAC anticipates opportunities to add risk during the potential volatility of the early stages of economic recovery.
- The Committee maintained its overweight view.
- Commodities could provide exposure to a surge in pent-up demand from consumers and manufacturers as uncertainty lifts next year.
- Gold and other precious metals could serve as a haven during any periods of uncertainty in the early stages of the economic recovery, as well as a hedge against fiat currency depreciation—although caution is warranted given the strength of the U.S. dollar so far this year.
- The Committee maintained its underweight view.
- After providing much-needed ballast for portfolios through the worst of the coronavirus crisis, the major liquid alternative strategies have less of a role to play as the recovery gains a firmer footing.
- Opportunities are growing in merger arbitrage and distressed.
- Some uncorrelated strategies, such as insurance-linked securities, could still provide useful diversification over the anticipated volatility of the coming months.
- The Committee maintained its overweight view.
- Very few transactions are being completed in companies that are highly exposed to coronavirus risk, which means that current deals are mainly in robust businesses.
- While that raises concerns about valuations, the operational enhancements that private equity can bring could be an effective tool for mitigating that risk.
- There are emerging opportunity sets in co-investments and arguably a multi-year value opportunity in private equity secondaries.
- The Committee initiated an overweight view.
- While some portfolios may be exposed to legacy assets affected by the coronavirus crisis, those focused on higher quality assets have fared well and are positioned to benefit from of favorable current conditions.
- As during the period following the financial crisis of 2008 – 09, traditional lenders are likely to be less active and leave more market share to private debt funds, while risk-averse private equity managers are putting more equity into deals, thereby creating a deeper loss-taking cushion beneath leveraged lenders.
- The Committee initiated a neutral view.
- Vulnerability to the coronavirus fallout in sectors such as retail and offices is likely to be at least partially offset by potentially significant opportunities in sectors such as warehouses, “last-mile” storage and datacenters that are geared to the new working- and shopping-from-home era.
- Significant dislocations across these sectors create opportunities at the property and project level.
- The AAC maintained its underweight view.
- The currency is still overvalued based on purchasing power parity (PPP) metrics and faces headwinds from accommodative monetary policy, the compression of rate differentials with the rest of the world and the U.S.’s twin deficits.
- The dollar could benefit from this being a U.S.-led recovery, however, and in the earlier stages uncertainty or potential volatility could also result in short-term dollar rallies.
- The AAC maintained its neutral view.
- The euro tends to be positively geared to global economic activity, particularly relative to the U.S. dollar; it benefits from a large current account surplus; and the installation of Mario Draghi as Italy’s Prime Minster has reduced political risk.
- The view remains marginal as the already accommodative European Central Bank is unlikely to tolerate further threats to its inflation target from an overly strong currency, markets are already long the euro, and the region is struggling to re-open under a new wave of coronavirus infections and a stuttering vaccination program.
- The AAC maintained its overweight view.
- Both PPP and real exchange rates suggest the JPY is undervalued, while very low yields globally now make Japan’s low rates less discouraging, and hedged foreign investments are at their most attractive levels for years for JPY-based investors.
- Continued funding stress in Japan and a consolidation of investor risk appetite as the recovery takes hold could be negative for the yen.
- The AAC maintained its overweight view.
- The market has clarity on Brexit, the recent U.K. budget is growth-supporting this year, the country’s vaccination program has been a success, and the GBP still appears undervalued based on PPP measures.
- The AAC maintained its underweight view.
- The Swiss franc is still very overvalued on PPP measures, market participants remain very long in their positioning, the installation of Mario Draghi as Italy’s Prime Minster has reduced political risk in the eurozone, and the CHF remains one of the most attractive funding currencies for global carry trades as global yields rise.
The Asset Allocation Committee (“the AAC” or “the Committee”) favors non-U.S. over U.S. large-cap equity markets, as well as emerging markets debt as part of its preference for credit over core government bonds. Its view on where the marginal dollar of non-U.S. allocation should go is informed by a number of factors, including what has been happening with U.S. inflation expectations and their implications for the strength of the dollar.
The dollar has strengthened so far this year, but it is very difficult to disaggregate the causes of that strength. Nominal U.S. yields have soared, but real yields and short rates have lagged, pushing up breakeven inflation rates. So, has the dollar strengthened in response to higher nominal yields and breakevens, or is there much more to come in the event that real yields and short rates catch up? Is the strength a reflection of stimulus-boosted U.S. growth expectations for this year, or a dramatic mispricing of its ballooning twin deficits?
On a 12-month view, the Committee currently downplays the risk of unmanageable inflation and expects nominal yields to come back in line with real yields and short rates. But it also recognizes that, unlike a decade ago, this economic recovery will likely be U.S.- rather than China-led. A substantially stronger dollar is not our central outlook, then, but it is a significant risk.
That makes the Committee marginally less favorable toward emerging markets equity and local currency debt, whose exposure to dollar strength has shown up in relatively poor performance so far this year. A systemic failure in a major emerging market is one of the tail risks for 2021 identified by some Committee members—with renewed questions over the independence of Turkey’s central bank currently making it the prime candidate. Asia and especially China are preferred over Latin America, reflecting a likely bigger benefit from the U.S. fiscal stimulus and revival in U.S. consumer spending. Higher inflation, a shift to tighter monetary policy and rising risk premia in response to several large fiscal stimulus packages adds to the dollar-related pressures in local currency bonds. Where we have upgraded our view on emerging markets debt, it is on dollar-denominated bonds.
European markets also look less favorable than they did a few months ago, as a number of countries struggle with a third wave of coronavirus infections and a stuttering vaccination program, as well as a lack of fiscal firepower relative to what the U.S. has mustered.
That leaves Japan as our most favored non-U.S. market. The TOPIX Index, up some 10% this year, has almost kept pace with U.S. small caps. Japan’s exporting manufacturers are geared to a global cyclical recovery and many trade at relatively attractive valuations. Unlike many emerging markets, they generally benefit from a stronger dollar and weaker yen, as U.S. consumption sucks in imports. Perhaps most interestingly, the country’s corporate management appears to be experiencing a quiet revolution in attitudes to shareholder value. A growing number of activist events has started to make management much more responsive to shareholder proposals. We believe the recent success of Neuberger Berman’s own Japan equity engagement team is testament to that trend. Both they and Neuberger Berman’s private equity team in Japan see a lot of opportunities where capital expenditure remains modest and costs can be reduced—and where management has become much more open to new ownership and new ideas.
This quarter saw the Asset Allocation Committee (“the AAC” or “the Committee”) add private debt to its list of discrete asset classes.
Private debt is a broad and diverse category encompassing investments across a spectrum of corporate credit, asset-backed, and real estate lending. One important area of the private debt universe is first-lien debt financing of private equity leveraged buyouts (LBOs). This category is quite distinct from private equity: its maturities are short relative to the average lifecycle of a private equity investment, it generates regular interest cash flows, and it is senior to and therefore less risky than equity. Its illiquidity, the way it is originated, and its risk-and-return profile also make it quite distinct from public high yield bonds and bank loans. In addition, it is finding its way into more and more investor portfolios as income with limited interest rate risk has become harder to find in traditional fixed income asset classes. Whether as a standalone allocation or as part of a full-spectrum, flexible, public-to-private credit strategy, this segment of private debt is becoming an important part of the investor toolkit.
The Committee opted for an overweight view for this category to reflect the fact that, while some private debt portfolios are struggling with legacy assets in sectors badly affected by the coronavirus crisis, those focused on higher quality assets have fared well and are positioned to take advantage of favorable current conditions.
The supply of lending opportunities is promising. The last five years were very successful for private equity fundraising, and because private equity dealmakers have been unable to travel for a year there is some $500 billion of dry powder waiting to be deployed in U.S. buyouts, all of which will need to be leveraged with debt. After the global financial crisis of 2008 – 09, it took five years for traditional bank lending to return to pre-crisis levels; we think the fallout from the coronavirus crisis may leave a similarly big slice of the market open to private debt funds.
The risk profile is also attractive. Let’s look again at the post-financial crisis era. After hitting almost six-times EBITDA in 2007, the debt deployed in the average mid-market LBO fell to just three-times in 2009, and leverage stayed below pre-crisis levels for another three years. Private equity investors generally wanted less leverage because they were more cautious, but also because lenders demanded more compensation for their risk. The net result was higher risk-adjusted returns to private lending. We believe similar conditions could prevail over the coming years, consolidated by a general turn away from a reliance on excessive leverage and toward more active management among private equity managers.
We believe this makes it possible to earn attractive yields from high quality assets, on top of a large cushion of loss-taking equity, with floating rates offering a potential buffer against the threat of rising Treasury yields.
Joseph V. Amato serves as President of Neuberger Berman Group LLC and Chief Investment Officer of Equities. He is a member of the firm’s Board of Directors and its Audit Committee. His responsibilities also include overseeing the firm’s Fixed Income business.
Previously, Joe served as Lehman Brothers’ Global Head of Asset Management and Head of its Neuberger Berman subsidiary, beginning in April 2006. From 1996 through 2006, Joe held senior level positions within Lehman Brothers’ Capital Markets business, serving as Global Head of Equity Research for the majority of that time. Joe joined Lehman Brothers in 1994 as Head of High Yield Research. Prior to joining Lehman Brothers, Joe spent ten years at Kidder Peabody, ultimately as head of High Yield Research.
He received his BS from Georgetown University and is a member of the University’s Board of Regents and the Business School’s Board of Advisors. He is also Co-Chair of the New York City Board of Advisors of Teach for America, a national non-profit organization focused on public education reform.
Raheel Siddiqui, Managing Director, Senior Research Analyst, joined the firm in 2004. Raheel is the Senior Investment Strategist in the Neuberger Berman Global Equity Research Department. In this role he researches impending inflection points in the business cycle, risk appetite, inflation, global asset classes, US sectors, style (growth vs. value), and size to enhance fundamental stock selection and portfolio construction processes by taking advantage of emerging trends not fully appreciated by the market. His research spans finding systematic ways of distilling leading or confirming messages from macroeconomic, quantitative, derivatives data, and behavioral data as well as periodically evaluating portfolios for efficient asset allocation.
Prior to this role, Raheel was a part of Lehman Brothers US Equity Strategy Team where he co-authored over 100 strategy reports, many of which were quoted in the Wall Street Journal, Financial Times, and Barron’s. Raheel also worked as a senior member of the Corporate Development team at Monsanto for six years, where he developed industry leading and award winning approach for valuing genomics assets.
Raheel earned MS/BS degrees in Biochemical Engineering from the Indian Institute of Technology and an MBA from Columbia University. Raheel has also been published with the American Institute of Physics.
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